Joseph Stiglitz: The financial crisis was a market failure - YouTube

2008 was a traumatic experience for  homeowners, workers, and for economic  

theories that markets worked well. Literally  millions of people lost their home. Tens of  

millions of people lost their jobs. The regulators had such belief in the  

efficiency of the financial markets–in being  good for the bankers, they will be good for  

all of our society. That, too, turned out to  be wrong. The very idea that the markets were  

efficient and stable was totally devastated. Before the crisis, scarce capital was allocated  

clearly to uses that were not good. Building  shoddy homes in the middle of the Nevada desert  

that will shortly remain empty and be destroyed.  Afterwards, the shortfall between the economy’s  

potential to produce and its actual production  is in the trillions and trillions of dollars.  

No government has ever wasted money on the scale  or the consequences of the US financial crisis. 

Our belief, our understanding that markets are  efficient is based on a very simple model–perfect  

competition, perfect information. A kind of  rationality that people really think through  

the consequences of their actions and another  very important assumption is no externality;  

there is nothing that I do that has effects on  others that is not already taken into account  

by the market. All of those assumptions were  wrong and were proven wrong by the crisis. 

Economists usually begin by thinking about  incentives, that people have incentives to  

behave badly and the answer is yes. What were  those incentives and why were there those  

incentives? And in fact they had incentives  to create incentive structures that were bad. 

In the late 90s we formed these mega mega banks.  These banks became ‘too big to fail’. If you take  

a risk and you win you walk off with the profits  but if you gamble and lose the government picks  

up your losses. There is an innate incentive to  undertake excessive risk, exactly what they did. 

When you have an economic system like that  the ‘too big to fail’ banks can get access  

to capital to lower interest rate. Because  those who lend out money say there’s no risk  

because the big government will bail it out if  they make a mistake. So, the ‘too big to fail’  

banks get bigger and bigger, so the system has a  dynamic instability to become even more distorted. 

Inside the firm you look at the incentive  structures; managers of the banks got a  

large percentage of the profits if things  did well. If, as a result of those gambles,  

the next year they lost, they didn’t have  to bear the consequences. As an economist  

I looked at the incentive structures and  predictably they led to bad behaviour. 

Many of us believed before the crisis you needed  good regulation. Those who were caught up in the  

euphoria of the pre-2008 world pretended  that there were no externalities. We’ve  

had economic fluctuations before. When banks go  down many people suffer and that’s especially  

true when we have ‘too big to fail’ banks. The reason they’re ‘too big to fail’ is because  

there are these macroeconomic consequences.  So, we have this vocabulary that recognizes  

that there are macroeconomic consequences and we  had regulators that pretended that there weren’t.  

It was what you might call a perfect storm,  perfect recipe, for a massive market failure. 

The basic lesson that I think should be  taken away from the crisis of 2008–markets  

on their own are not efficient or stable. We  realized that there are these externalities,  

there are things that one person can do,  one organization can do, that affect others. 

We’re never going to get to what we would  say is a perfect working system but we can  

get something much better than we are now.  We’re always trying to strive to get the  

right balance. We know that a system in which  the state does everything doesn’t work. The big  

lesson of the crisis of 2008 was that we  could lose balance on the other side too.